Question

Cornell Green, process engineer, knows that the acceptance of a new process design will depend on its economic feasibility. The new process is designed to improve environmental performance. On the negative side, the process design requires new equipment and an infusion of working capital. The equipment will cost $300,000, and its cash operating expenses will total $60,000 per year. The equipment will last for seven years but will need a major overhaul costing $30,000 at the end of the fifth year. At the end of seven years, the equipment will be sold for $24,000. An increase in working capital totalling $30,000 will also be needed at the beginning. This will be recovered at the end of the seven years.

On the positive side, Cornell estimates that the new process will save $135,000 per year in environmental costs (fines and cleanup costs avoided). The cost of capital is 10 percent.

Required:

1. Prepare a schedule of cash flows for the proposed project. Assume that there are no income taxes.

2. Compute the NPV of the project. Should the new process design be accepted?

Answer 1

Given

Equipment	$300,000
Life	7	years
Residual Value	$24,000
cash operating expenses	$60,000	per year
Working capital	$30,000

Working Note:

Savings	$      135,000
Costs	$ 60,000
Net cash flows every year	$         75,000

Year	Particulars	Net Cash flows	PVF@10%	PV cash flows
0	Investment & working capital	($330,000)	1	($330,000)
1	Net savings	$                         75,000	0.90909	$         68,182
2	Net savings	$                         75,000	0.82645	$         61,983
3	Net savings	$                         75,000	0.75131	$         56,349
4	Net savings	$                         75,000	0.68301	$         51,226
5	Net savings-overhaul exp	$                         45,000	0.62092	$         27,941
6	Net savings	$                         75,000	0.56447	$         42,336
7	Net savings	$                         75,000	0.51316	$         38,487
7	Working capital + Residual value	$                         54,000	0.51316	$         27,711
			NPV	$44,214

Its recommended to adopt and implement the new process as its NPV is positive and implementation is economically viable.